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Features : Growing Pains

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As custody outsourcing comes of age, it is undergoing a transformation.

Rob Mancuso, senior vice
president at Investors Bank & Trust

Outsourcing in custody is as old as custody itself. After all, the industry developed to meet regulatory requirements to separate custody and investment management.Then,seven years ago,the market took a leap forward with a handful of mega-deals that transplanted asset managers’ middle-office functions to custodians. It hasn’t looked back since.

The market has huge potential. The investment management universe is about 500 firms, with assets of $30 trillion, according to Alan Greene, executive vice president of US investment services at State Street. Pressure on fees and hugely escalating technology costs is expected to make outsourcing of many middle-office functions inevitable.

“The pressure on profitability over the past few years has meant that investment managers have realized that they can’t spend money on every new technological development that takes place,” says Tom Perna, senior executive vice president, global services, at The Bank of New York. “Generally operations and technology have become more expensive, and outsourcing is one way to save costs.”

In addition to cost savings, the benefits of outsourcing include risk avoidance. “If we do the bulk of the backand middle-office functions for a client, then we must be able to guarantee the quality and absorb the cost of any mistake,” says Rob Mancuso, senior vice president at Investors Bank & Trust.“Also, in the current regulatory environment it can be reassuring that a third party is doing compliance checking and auditing.We have no factors compromising our integrity in that regard,” he adds.

Steve Fradkin, executive vice
president at Northern Trust

As firms focus increasingly on their core competencies, fund managers are now asking themselves, ‘Is this an investment process or an administrative process?’ according to Steve Fradkin, executive vice president at Northern Trust.“‘Why should we focus on activities that are not directly linked to investment decisions if there are outsourcers that occupy that space as a core competency?’ Accordingly we are seeing a growing interest in outsourcing middle-office trade communication functions,” Fradkin notes.

Paula Sausville-Arthus, asset manager solutions group executive at JPMorgan Investor Services, says that changes in the industry itself are encouraging outsourcing. The outsourcing trend began largely because of initiatives connected with Y2K and EMU, and industry initiatives such as Swift continue to require careful consideration by investment managers.“Such initiatives involve large investments with no meaningful return to the firm’s bottom line,” she says.“In a bear market in particular, these issues generate cost challenges.”

But the end of the bear market may have put the brakes on the expansion of outsourcing, according to Taylor Bodman at Brown Brothers Harriman.“The theme of outsourcing gained increased prominence during the bear market when people wanted to swap fixed costs for variable costs; people only wanted to pay for what they used because they had less funds under management,” she says.“Now that the markets have improved, some of outsourcing’s traditional economic edge has softened.”

Bodman’s argument that the recovery of the equity markets in 2003 has slowed outsourcing also informs her thoughts on how outsourcing will develop.“We’re not expecting a significant increase in the number of very large outsourcing deals,” she says.“Because of their size and complexity, lift-outs will never become commonplace.”

This is the crucial dividing line between players in the custody industry:Some support a wholesale lift-out model while others believe those early deals with major players such as PIMCO and State Street, JPMorgan and The Bank of New York, and Investors Bank & Trust and Barclays Global Investors cannot be repeated throughout the industry.

Northern Trust’s Fradkin believes that the transfer of people, systems and other assets from the investment manager to the outsourcing provider is “not economically viable in the long term.” He adds,“Indeed, it can be more expensive … because of the additional oversight costs outsourcing entails.”

The Bank of New York’s Perna agrees that many of the large outsourcing deals have been shortsighted: “Some providers have paid too much upfront in order to win mandates.They are looking for reduced costs in the long term,but at the moment the deals look questionable. Liftouts are a recipe for disaster unless they can be used as a framework for providing services to other clients.”

The objective of the outsourcing providers is to migrate clients to a lower-cost, common platform that can be used by many clients. But, as Fradkin notes, if outsourcers continue to operate on multiple client platforms, it is difficult to see where the industry’s scalability will come from.

Mancuso says Investors Bank & Trust is addressing that problem following its $500 billion outsourcing deal with Barclays Global Investors three years ago. “For the first one or two clients you are inevitably tailoring services. But the systems that we have designed for our single outsourcing platform will fit any manager. For all outsourcing endeavors we use a standard operational infrastructure and make it flexible,” he says.

Modular Approach Wins Approval

The argument that systems designed for one large investment manager should work for another firm has a further nuance. Rather than applying systems and practices from one firm’s outsourced functions to another, some in the industry argue that the model of outsourcing has to change.“There are still big deals out there, but there is increasing interest in individual components such as trade operations or messaging rather than wholesale divestiture of investment operations,” says Sausville-Arthus. Bodman agrees:“There is likely to be a long-term inevitability to outsourcing, but it will be a modular, incremental approach.” Sausville-Arthus adds, “Firms are more comfortable with that level of outsourcing, which addresses concerns about loss of control.”

Middle-office functions that have most acceptance with regard to outsourcing include trade management, reconsolidation, compliance and communications.“Middle- office functions such as handling communications between brokers and other custodians and trade operations management are areas of current outsourcing interest,” says Mancuso. “However, many clients have decided to retain data warehousing as an internal function perhaps because of concerns about data confidentiality.”

A modular approach to outsourcing also brings its own problems. Bodman notes that Brown Brothers Harriman supports open architecture and recognizes that diversification is good for clients.“We aim to build tools that allow investment managers to work with different counterparties. However, it remains true that the more business you do with one counterparty, the better deal an investment manager is going to get,”she says.Mancuso says that at the current time “it would be complicated to outsource middle- office functions to more than one firm.”

A pervasive view among those in the custody business is that outsourcing is still at an early stage, somewhere between infancy and adolescence. As Northern Trust’s Fradkin says,“It is too early to judge with any certainty which models will prevail and optimize fund manager performance.”